Speaker 1Capital Allocators is brought to you by AlphaSense. Here's something for you. Most AI tools today are very good at sounding right. But can you actually trace it back to a filing, transcript, or specific passage that drove the answer? Or are you just trusting the confidence of the output? For allocators, that's not a minor concern. A missed filing, incorrect source, or context that gets lost somewhere in a retrieval chain aren't edge cases. They're how decisions go wrong. AlphaSense is the AI platform built specifically for this. They own the content. Over 500 million curated documents from broker research and expert transcripts to filings and earnings calls. And they own the retrieval layer on top of it. That means every answer can link back. Back to an exact, verifiable source. Because the answer is only as good as what's underneath it. And with AlphaSense, you know exactly what that is. See it for yourself. Try a free trial at alpha-sense.com slash capital. That's alpha-sense.com with a hyphen in the middle slash capital. Capital Allocators is also brought to you by Morningstar. In a sea of data, you need to know. What you can trust. Morningstar's data, analytics, and research helps bring clarity across public and private markets. Connecting independent research and data into the tools and AI platforms you use every day. So insights are easier to spot and act on. Morningstar. Nothing in your way. Visit morningstar.com slash game on to learn more. Hello, I'm Ted Seides, and this is Capital Allocators. This show is an open exploration of the people and process behind capital allocation. Through conversations with leaders in the money game, we learn how these holders of the keys to the kingdom allocate their time and their capital. You can keep up to date by visiting capitalallocatorspodcast.com. My guest on today's show is Raphael Arndt. The chief investment officer of Australia's $145 billion sovereign wealth fund, the Futures Fund. Raphael trained as an engineer and dove into infrastructure policy at the beginning of Australia's privatizations in the late 1990s. After investing in the space for six years, he joined the Futures Fund in 2008 to head the infrastructure team. Six years later, Raphael became chief investment officer. Our conversation spans all aspects of the management, including a one-team, one-portfolio philosophy, disaggregating beta and factors from skill in public markets, separating the impact of leverage and timing from skill in private markets, venture capital and co-investment opportunities in a large pool of capital, the option value of flexibility, the team required to make decisions in this format, compensation, fees, views on China and the current market environment. Australia created the Futures Fund only 11 years ago with a mandate to compound capital for 20 years before even contemplating withdrawals. It has been described to me as a pool of capital with the size and transparency of CalPERS and the sophistication of Yale. I'm sure you'll soon understand why. This week, I'd like to pretend that I'm a contestant on the television show Who Wants to Be a Millionaire? by asking you for a favor. First, just like phoning a friend on the show, could you reach out to just one friend, an email will suffice, and tell them about Capital Allocators? If I did the math right, we should be able to double the already sizable audience with that one simple act. Second, like polling the audience for an answer on the television show, would you take a moment and write a review on iTunes? It will help others we don't know learn about Capital Allocators. Thanks so much for spreading the word. Please enjoy my conversation with Raph Arndt. Well, Raph, thanks so much for joining me. Thanks, Ted. Why don't we start with how someone comes to be the Chief Investment Officer of a sovereign wealth fund?
Speaker 2Sure. Well, it's an interesting journey in my case. It certainly wasn't something I planned from early in my career. I actually started by studying civil engineering and economics. And started life as a civil structural engineer. Spent some time in the UK with a consulting firm and then ended up designing oil platforms of all things. And then came back to Australia and decided that the future career in engineering while it was there for me was probably not stimulating enough compared to what I was interested in. And because I'd done economics and a bit of finance and at that time in the early 90s, Australia was just. starting down a path of privatising infrastructure assets and working out how to procure government services jointly with the private sector. I became quite interested in, I guess, what we might call private infrastructure. Yeah. Which was a much more novel concept in the early 90s than it is today. And it appealed to me because it was not just within my technical wheelhouse, but because it had elements of law and politics and social services and finance. Finance that I had been exposed to and interested me. So I decided that was an area I wanted to get into, but it wasn't really an industry. So I started asking around and eventually decided, believe it or not, to actually leave my job and go and do a PhD on private infrastructure policy. Not because I wanted to be an academic, but because I thought it was an entrance into an industry that was just starting and I could meet lots of people. And as it happened, I ended up. I ended up working very closely with the state treasury through that time on infrastructure policy and meeting a lot of people in the industry. So I was lucky enough when I finished to get a job through some people I met as, I guess, in the US, what you might call a lobbyist, but it was really a policy-driven role for an industry advocacy group. And I never wanted to do that for a living either, but it was some good skills and I certainly learned how to articulate a complex message clearly, and again, I met a lot of people. And so a couple of years later, I was actually able to move to a role for a boutique infrastructure fund management business called Hastings Funds Management, which was based here in Melbourne, and then spent seven years there learning the trade, learning how to be an investor. And so by the end of that time, was the portfolio manager for one of their unlisted infrastructure funds. And again, through luck, I would say, I learned a lot of timing rather than, than anything else. That happened to be the time that the Future Fund was being established and among other things, they were looking for someone to head up their infrastructure team.
Speaker 1How did the formation of the Futures Fund come to pass?
Speaker 2So in the early 2000s, Australia had benefited from some degree of the resource boom as China emerged. And through a combination of that and economic management by the government at that time, the federal government budget was in surplus and was expected to be in surplus. And the government had been paying down the federal government debt to the point where the industry started to get concerned that all the bonds would be retired and there'd be no reference rate for the industry. And so the government was faced with the great problem of saying, what do we do with the money? Do we up our spending? Albeit that we don't think this situation may be sustainable. Like many, many governments, it had a series of pension fund obligations that were not met. They were unfunded. And so instead it decided to establish the fund to invest that money, but also they privatized Telstra, the main telecommunications company around that time. And the bulk of the money in the Future Fund actually came from the proceeds of that sale and set up an organization to invest that money with a view to allowing the government to draw down in the future to offset the unfunded pension liability.
Speaker 1What was the initial size of that pool of capital?
Speaker 2Well, if you include, all the inflows over a year or so, it was about $60 billion Australian dollars, of which about $50 billion was in cash. About $10 billion was in Telstra shares that were still in escrow and were not allowed to be sold for two years.
Speaker 1So that's a large amount of money you just start thinking about putting to work.
Speaker 2It's a unique situation really, because what we had was a new business, really a startup being formed, but with $60 billion on the balance sheet. And so that was a pretty big deal. It was a pretty exciting place to be and a great opportunity, which I was very strongly attracted to in terms of the infrastructure role. But also it gave us the opportunity to create a new way of investing large institutional long-term money from scratch with no legacy systems, no clients, and just blue sky. So I was brought in to do the infrastructure role and very quickly I also inherited this responsibility for selling down $10 billion of Telstra shares. which I didn't know all that much about at the time but quickly learned. And I did that job for about six or seven years, establishing the portfolio and the team and the approach. And then through some internal changes, my boss, the CIO, became the CEO, and I was lucky enough to get the CIO gig.
Speaker 1Yeah. So let's start with your initial entrance and the creation of the fund in the first place. What was the strategy?
Speaker 2Yeah. So I would say I came in partway through that process. The fund had been established through an act of parliament in 2006. The board had been appointed, and the board was just getting down to appointing a team that hired a CEO, a person called Paul Costello, who also had been involved in establishing New Zealand Super, and very wisely made the decision that it was better to build the back office and the custody system and the legal approach first before you start hiring investment people, because believe it or not, investment people want to start investing. So it wasn't until around the middle of 2007 that David Neil was appointed as the CIO, and he came from an asset consulting background, and so I think he's very good at strategic thinking, and he really had a very strong philosophy that he built together with Paul, which was, let's look around the world at other large funds, many of whom are tremendously successful, but figure out what constrains them and how we can address that. Yeah. There were a few simple ideas. One was to think about what many people today call total portfolio approach, but we called it one team, one portfolio. We're all in it together. We won't worry about diversifying individual asset class portfolios. We'll just do what's right for the whole portfolio. It's a very simple concept, but actually it's very hard to do in an existing organization, and we had the benefit of starting from scratch.
Speaker 1To start with that, what are some of the things you would do differently with one team, one portfolio than what you said? What are some of the things that you saw in sort of legacy teams?
Speaker 2Well, I'll just give you one example. There's many, many examples, but one very simple example is today we have a portfolio like all of them, really, of our size, which is very growthy and very exposed to equity risk premier, and we know that in certain scenarios, for example, a big recession or a market sell-off, that portfolio will not do so well, and so positions that can hedge against that are very, very valuable. So we have a couple of hedge fund strategies that really are sort of volatility traders or tail protection type mandates, and if we had diversified hedge fund portfolio, and if the person running that or the team running that were incentivized just based on the hedge fund performance, they may have those positions, but they would size them relatively small because in most scenarios, we expect to lose money on them, or at least not make very much. In our case, we actually size them very big, or at least 4%. So we have a couple of hedge fund strategies that really are sort of volatility traders or tail protection type mandates, and if we had diversified hedge fund portfolio, and if the person running that or the team running that were incentivized just based on the hedge fund performance, they may have those positions, but they would size them relatively small, because in most scenarios, we expect to lose money on them, or at least not make very much. Or at least from their perspective, very big. It might be, say, 20% of the total hedge fund book, because they're actually designed to pay off at a whole of fund level in those scenarios.
Speaker 1Yeah, it makes sense. So that's the first principle, one team, one portfolio.
Speaker 2Yeah. The second thing was, we call it being joined up. And what we mean by that is, most funds, I would say, they're quite backward looking in their portfolio construction. What I mean by that is they take this sort of CAPM theory and their main variance, I'll say, and they take this sort of CAPM theory and their main variance, I'll say, and they look at historic data, and they then optimize the portfolio using that data. And by design, that assumes that assets continue to behave in the future the way they behaved in the past. But I don't think there's any reason to assume that, and I think that today, there's reasons why that may not be the case. Sure. And so we try to have a forward-looking process. And quite a few funds do this today, where we think of asset classes not so much as sectors, but. Through their factor contributions, so how much exposure to equity risk premium, credit risk premium, inflation, duration, illiquidity premium, those types of things. And we can then look forward using a scenario analysis and say, OK, in a stagflation, in a recession, in an emerging market slowdown, or productivity boom, what would happen to those factors, and therefore the assets themselves, but also how would correlations change? And we can start to look at. And we can start to look at the portfolio on a forward-looking basis. Typically, what funds do, because they're very large and they are complex organizations, is they then come up with a portfolio allocation. Maybe they've got a strategic asset allocation, and they exercise a tilt away from that. And then they ask the sector teams to fill up those buckets to buy assets. The problem with that approach is that the top-down and the bottom-up are very disconnected, and the asset teams, which in many cases might even sit in another country. So the top-down team, they don't understand the fund's macro view or the fund's portfolio construction, the risks, the exposures. And in reality, those teams, if they're sophisticated, they can build a portfolio to match a desire. So a property portfolio doesn't have to be vanilla real estate. You could target certain types of property or exposure, the same in infrastructure or even equities. And so that's the top-down approach. The bottom-up approach is one where the teams just go out and buy the best assets. They can. And they might try to risk adjust the hurdle rates. That's quite nimble, because you can adapt to the market. But the problem is there's no real concept of portfolio construction, certainly at the whole portfolio level. And so we try to bring those things together by having a small team of 60 investors all in one office here in Melbourne, Australia. And we can all sit in a room and debate things frequently, and we do. And more so, the teams can work together. So that the economics team can say, well, I'll give you a real example. When I was running infrastructure, we were looking at a toll road opportunity in Spain just after the financial crisis. And so the value of those assets had fallen very significantly, as had all assets. But the Spanish economy at that point still looked reasonable. And so the view from the bottom-up was, these are great assets, they're a great opportunity. And it was only by talking to our economics team that we understood that there was a big risk of a financial crisis in Spain, given the positioning of the banking system. And we could start to take that into account in how we thought about the valuation. Equally, our teams that are involved with airports and shopping centres and seeing companies repaying their credit obligations on time or not, can inform the economics team about what's actually going on in the real world and help to influence their thinking about the opportunity set and the economic outlook. So we call that being joined up. Okay. The third thing is being nimble and flexible. And that's really about being prepared to do something differently, not doing things the way they've always been done, understanding why you would do something and being prepared to make the call and to take some risk. We're in the business of taking risk. We need to understand it, but we can't deliver returns unless we're willing to take them.
Speaker 1Yeah. How do you lay that out in a process when you have a governance board of what that strategy is to be nimble and flexible? Well, you need
Speaker 2to have a very clear language that you can speak. And so, with our board, they're all people with some experience in financial services. We've developed a language. The Future Fund mandate says, "Maximise return. In doing so, don't take excessive risk," which is pretty high level. We do have a benchmark from the government of inflation plus 4% to 5% over the long term that they've given us. The way the board has interpreted that is to say we should vary risk in the portfolio. It's not a set and forget strategy. So if risk is being rewarded, we should take more. And if risk is not being rewarded, we should take less at a point in time. And then secondly, we think about risk in terms of the cumulative drawdown over a three-year rolling period. Because we think as a public fund, we've got a responsibility to the public and to the taxpayer. The bigger drawdowns over longer timeframes could be tested and could potentially lead to poor decision-making. So we debate those metrics with the board from time to time, but we've got a very clear language and we have quite open conversations with the board about why we're doing certain things. So for example, that discussion about the hedge fund tail protection strategy, we have that open conversation with the board. We're making this investment. We think it will probably not pay off in most scenarios. It will pay off when we really need it.
Speaker 1And what are the metrics that you think about when you try to determine whether it's a good environment to take risk or not?
Speaker 2Well, the first thing to make clear is we certainly don't believe that we can time markets. It's not an exercise in market timing. It's not a short-term strategy. We've got plenty of macro hedge funds that do that on our behalf, and we don't think we can do it better than them. But we do think if you draw a line today. And look forward, it's possible to predict, for example, what is the implied equity risk premier, because we can have a view on long-term growth on corporate margins. We can sort of work out what we think the earnings are going to be. We can take the long bond rate or some forecast beyond that and say, disaggregate that and say, what is the implied equity risk premier? And that's actually a pretty good predictor of future returns over 10 years. So. And so. A lot of the expected return drivers. That's probably the main one, but obviously there's things like term premier and other other asset classes that come into it and then in terms of risk I would say it's quite a qualitative process so we debate the issues of the day but today we're quite focused on the healthy economy in the US however that probably indicates a return to the normal business cycle and that means that as interest rates rise slowly eventually that will start to impact on what is still a reasonably indebted economy and slow economic activity and usually markets will lead that impact we've still got monetary policy that's accommodative we've got fiscal stimulus happening and so there's quite a bit of downside risk in the longer term and then we're also looking at things like geopolitics trade disputes and things like that which populist politics in general is usually detractive from economic growth and inflationary and so there are risks that are out there on the horizon we think risk is building at the moment over that time horizon
Speaker 1so that sounds like you're the general top-down case of what you're looking at do you start with that and then bottom up and then marry it how does that work
Speaker 2yeah that's exactly right so we start with that view all of our bottom-up sector team leaders are involved with that conversation and then why we would translate that for example in property in real estate would be that no view is ever certain we've got to be humble in our abilities but let's say we thought it was then assets with long duration would be at risk because if we think interest rates are rising and that's not fully priced in or economic growth might roll over and that's not fully priced in or inflation might break higher than expectations and albeit that real estate might have some ability to pass that through it will be limited by the capacity of the economy to carry it then actually your core long duration real estate assets should be seen as quite risky from a valuation point of view a bit like long bonds in that type of portfolio whereas shorter duration strategies that are more skill-based for example we're doing aged care development in the at the moment because the demographics are such that there's just a definite need for more facilities in that space or infill housing in places where because of the impact of the financial crisis people stayed at home longer and the millennials are now moving out of home and need places to live near a university near a hospital near employment centers those sort of skill-based shorter duration strategies become quite attractive in this environment they are riskier from a cash flow execution point of view but from a valuation point of view they've got a lot of buffer because the expected return is much much higher than the expected return so that's why we're doing that probably in the teens how
Speaker 1often can you change a view like that so if you're just talking about infrastructure real estate they're fairly illiquid assets so you rates could move meaningfully over a year or two but it's not so easy to turn the portfolio
Speaker 2no and nor do we try but we're taking a three year plus view if we thought something was going to happen for three years and then revert we probably wouldn't move an infrastructure portfolio but we know today that prices implied on those core assets are well in the single digits probably low later mid single digits and we just think there's a lot of risk around that so the first thing you do is stop buying them and because we're not setting top down asset allocations there's no need for the team to go and buy assets to fill a bucket in fact we'd encourage them to come back to the investment committee and say we think we should sell our assets and give this capital over to someone else who's got better opportunities so all of our alignment and all of our culture is designed around those types of interactions
Speaker 1how do you apply the top down view to your public market investments
Speaker 2it's quite similar so firstly equities are our key lever in terms of how much risk we want in the portfolio and we can dial that up and down relatively easily from a portfolio construction point of view for example we have a significant overweight to emerging market equities when you just look at for example the msc oil countries index why because we have very little emerging market exposure in private equity property infrastructure hedge funds and so from a total fund perspective we think we need a bigger exposure because they're probably misnamed these days but these economies are more than half of the global gdp are going to continue to grow faster than the developed markets more traditional markets but are not as accessible in terms of the development of their financial markets we also bring a factor lens and so we do invest the portfolio to target for example quality or value type opportunities but we've chosen not to for example chase momentum strategies because we have a lot of momentum in the rest of
Speaker 1the portfolio if you roll this all up what does that asset allocation look like today that's
Speaker 2a good question so the first thing i would say is well i will answer the question it's not as meaningful as it might be it needs to be discussed and we need some discussion because we don't really think of asset classes but the equity exposure overall is about 30 percent of the fund and that's roughly about half developed market equities and a quarter h of emerging market in australian equities in australia we don't pay tax we get some from sort of tax advantages under the australian rules and our mandate is in australian dollars and to australian inflation so we'd always have an overweight to australia but it's a much smaller overweight actually than a lot of our local peer funds would have because we're looking for diversification private equities uh probably about 12 of the portfolio at the moment and about half of that is venture and and growth equity so we've tried to tilt that away from buyout strategies that we feel are very similar to equities and the exposure they give us and towards something diversifying property and infrastructure between them are about 15 percent of the portfolio and those strategies have been tilted away from the core assets at this point in the cycle they have been there in the past and are more focused on the more skill-based shorter duration higher manager activity type strategies so they're higher risk than most asset owner property and infrastructure portfolios would be debt is about 10 percent that's been as high as well over 20 in the past and we've shrunk that as the opportunity set shrunk and the return for that particular risk has shrunk we have about 15 in hedge funds and other alternatives as a diversifier and then we're holding about 15 in cash at the moment and that's for its option value but we also have a series of overlays to give us currency exposure and duration we hold almost no physical bonds we don't have any concept of liability matching we've only got a return target and bonds aren't paying all that well at the moment so there doesn't seem to be a strong reason to hold them but we do have some rates exposure as a defensive asset class so
Speaker 1it's the way you talk about this with a thoughtful top down view and when you talk about the bottom up you're talking about specific assets it might lead me to believe that you do a lot of internal management but i know that's not the case
Speaker 2no in fact probably the last philosophical belief is that we call it leveraging the best in the world we actually don't manage any assets internally so we use managers for for all of our implementation and we've probably got about 120 or so managers on the books at the moment and would like it not to grow too much more than that just so that we have the bandwidth to keep on top of it and that we don't get over diversification but the team here so there's about 60 people in the investment team a lot of them are former fund managers or asset consultants who have interacted with managers and i'd like to think that we can go out and interact with our managers as peers in the marketplace we know their job we know what they do and we know what drives them a bit of poacher turned gamekeeper so we can have very sophisticated discussions with them and rather than buying the vanilla strategy we typically would design a strategy that suits us and then if they have one that we can buy off the shelf that's great and if not we can talk to them about building a specific strategy for us now i
Speaker 1i've had conversations with some of the other superannuation funds when their size got larger but let's say larger call 40 50 billion which is still a fraction of where you are today a lot of them shifted to internal management in part because of the difficulty in accessing external managers and you talk about 120 managers but that's on average what north of a billion dollars in each one yeah how have you navigated that landscape where the pool is so large that the investable opportunity set isn't really that large for you well certainly
Speaker 2capacity constraints are an issue that we need to think about obviously in in the more liquid asset markets particularly equities and bonds those are accessible although not all strategies so we do have some levers that can scale but we work very hard and we develop relationships with managers and we have to fight for capacity and we recognize that those relationships are mutual, they're two-way, and we try to be very open with our managers and share our views with them and give them our feedback rather than just reading their quarterly report and never talking to them. And so we would hope that our managers get something from us as well as part of that equation. And that helps us get access to capacity in the better managers. So it is a challenge, but we have to keep working at it.
Speaker 1Yeah. I'd love to dive into your thought process on each of the asset classes. So why don't we just start with listed equities and I'll let you take it from there.
Speaker 2Yeah, sure. So I guess when I came into the role, we'd been doing equities for, well, obviously since inception, that was about eight years, seven years. And the first thing we started doing was some attribution work. And I guess we're lucky enough today to be living at a time when the technological tools available to us are improving our ability to do that type of work. They weren't available a decade ago when we started the program. And what became apparent, very quickly, was that while the team had done a really good job of picking the best managers in a particular style, whether it was a value manager, an emerging market manager, a thematic manager, when we aggregated up all of the maybe 20 or so mandates we had across that portfolio, by and large, they cancelled each other out at the whole portfolio level. And I would have expected we would end up with something like beta, less fees. Now, actually, as I said, the team did a good job. And so we ended up with slightly better than the beta, which was a good outcome, but it was not ideal. And so even if you could pick a good manager, you still had to build a total portfolio that made sense. I sort of think of it like, if you want a car, you don't go out and buy the best steering wheel, the best seat, the best windscreen, and hope that you get a good car. You actually have a plan for a car and buy the parts that suit the car you want. So having built the technology to measure performance and disaggregate performance, we then sat down with the board and said, let's start from first principles. What are the objectives of an equities program? One, we think that the equity risk premier exists and it's pretty reliable. And so holding equities over a long timeframe, we think should deliver a source of return for a long-term investor. Now that's not rocket science, but it's important to state it very clearly, because if that's all you wanted to do, you would buy the beta and you would buy it as cheaply as possible. And in a small amount of time, you would be able to buy the beta and you would be able to buy it in the most liquid way as possible. Secondly, though, I think the research tells us today that there are certain types of factor approaches, particularly value and quality, but there are others that do seem to pay off over long time periods, albeit if you're worried about tracking an index or shorter term performance, you have to worry about that. In our case, we're not worried about that. We're only worried about whole fund performance in an absolute sense over the long run. And so developing a factor strategy, was high on the agenda. Now we've done those two things and we can execute those through third party managers for literally a handful of basis points in this day and age. And we do. When we looked at the portfolio originally, that was where the bulk of risk and the bulk of return sat in the beta and in the factors that the managers were selecting. So you picked a value manager, or if not, it's just a manager who had adopted a value style. And so there was no point at all paying a share for those sort of things. We do believe in active management. We do believe that skill exists and is sustainable. That in itself is something people could debate, but we believe in it. We don't think that skill is widely available in equity markets today. Technology means that it's being arbitraged away very quickly. And the manager business model and the way they charge essentially typically charges you for the beta return, the factor return and the stock picking skill. But only one of those deserves compensation. And so using the technology, we can disaggregate those things and regress against different types of factor returns and things like that and isolate where the skill actually exists and we'll keep those managers. Mainly our alpha program has now migrated to long short market neutral hedge funds because we can pick managers with pure skill and it's very evident if they have it or not very quickly. We're only paying for the beta return. But secondly, they have very concentrated portfolios. And so the likelihood that they're going to cancel each other out is very low. And we can track that in the system now and make sure that we're getting an efficient portfolio implementation.
Speaker 1So let's dive through that a little bit. When you started using the technology to do detailed attribution on the listed equity portfolio, what did you do with the managers that clearly didn't have the ability to do that? Yeah. They were really outperformed. Did you hold them? Yes. You did.
Speaker 2We have. There's not a lot of them, I would add, but yes, we have held them.
Speaker 1Okay. So some of them survive and that's stock selection alpha that you've determined after taking out factors. That's right. Then on top of that, you have say long short equities. You just mentioned concentrated portfolios. It struck me that most of the market neutral equity portfolios are multi-manager, many, many positions. In fact, they're not concentrated at all. So I'm curious, if you're really looking at stock selection skill, how are you isolating the stock selection alpha in a more concentrated book?
Speaker 2I should clarify, we have many managers in that strategy. They're mostly actually fund-to-fund separate account type mandates because we don't have the bandwidth in our team to track 30 or 40 underlying managers. But what we're doing is they're accounts that are designed in such a way as they're very unlikely to overlap. So each of those underlying managers might hold 20 longs and 20 shorts, for example. Our system can aggregate all of their positions and report back to us on an aggregated basis, either in isolation or overlying the long only portfolio. And we can see where if we've got position concentration, we can see if there's a rotation going on and we can take that information into our broader thinking in our own portfolio construction. And we can see where the alpha is
Speaker 1being generated. Have you thought about marrying off the pass-through separate account through a fund-to-funds or a large multi-manager hedge fund?
Speaker 2Well, we have some of those. So our manager list is on our website. It's quite public. And we have, for example, Citadel as one of those managers. So I think it's the same thing. It's just when we aggregate those things up, what are we getting? What are we paying for? Those large hedge fund strategy hedge funds, many of them have delivered significant beta, whether it's equity beta or credit beta. And that is not something we want to pay for. So I think it's just a matter of, again, in the same way, analysing the track record of these managers, regressing it against a whole variety of factors, in this case, things like carry and commodities, as well as bulk asset betas, where is the return coming from and only paying for the part that's valuable.
Speaker 1And having Juniper Square as your operations partner helps ensure your data is organized, accurate, and accessible so you can unlock operational alpha. That's why thousands of GPs trust Juniper Square. Learn more at junipersquare.com slash capital allocators. How have you thought about the construction of a core portfolio? So you can access, as you said, low cost market exposures, factors, some alternative betas. And then alpha on top. How important is it to own the core or to just access what you found is special in the alpha piece?
Speaker 2Well, if you go back to the objectives and also your comments about scale. So today the equity book is maybe $45 billion and we're just not going to find enough skill out there in the world to invest $45 billion. But also a pure alpha book does not give us the same amount of value. We've actually structurally taken the beta out of it. So this desire to get exposure to the equity risk premium only comes from those other things, but we can do it very, very cheaply in flexible.
Speaker 1Yeah. All right. Let's move on a little bit to private equity. How have you approached that investment area?
Speaker 2We approach everything the same way. The question is what can this asset class do for the portfolio as a whole? Under what scenarios will it pay off? Under what scenarios will it be penalized? How does that compare to some combination of equities and cash or equities and bonds? And so why are we doing it? So again, we don't set out to buy a diversified portfolio of private equity. I guess the typical portfolio construction would be 60 or 70% buyout, for example, and then a bit of growth and maybe a small amount of venture. Our portfolio has no large buyout at all and we think that large buyout is really just levered equities typically. And if there's skill and there might be then most of that goes away in fees so we don't think it adds a lot for the portfolio so our private equity portfolio is about half venture and growth equity and the rest is small buyout and what we're really looking for in private equity is two things one is a clear sustainable outperformance over equivalent equity indices after adjusting for market timing ability by the managers so we're not interested in people who can just time markets putting capital in and out because if we're doing that we're probably putting the money in equities when it's not sitting with the private equity manager and so we started by identifying managers with real skill who can improve a business not just slice and dice it or listed or delisted and move the money around because as someone approaching a universal owner we're going to own it whether it's listed or unlisted and there's no point just paying fees for those transactions and how do
Speaker 1you do the due diligence to figure that out well
Speaker 2it's quite analytical so in most cases we would like a manager with some track record and we would like to understand the underlying performance data at the asset by asset level so we would deliver the returns would take the use of debt out because usually just using more debt gives their lps more risk and more upside for the manager but with a lot of downside risk and we take the market out and we're going to be able to do that so we're going to be able to take the market timing out by doing something called a public market equivalent analysis which is really just saying if we take the cash flows that go in and out of this private equity account and put them in the equivalent equity market index with the same timing what would the return have been and then compare those two things and
Speaker 1what do you find as you look at a group of managers compared to your sense of how the industry looks at the same group of managers well there's a lot
Speaker 2of brand names we don't have and it varies a lot between the two so I think it's a good idea to go back and look at a group of managers and see if there's anything that you can do to make sure that they're doing a good job and that's why but one of the most significant reasons is because they just use leverage we found to juice up their returns and we don't think that's attractive and we're really focused on the smaller managers that have a tremendous amount of skill in how they can improve business it's not just where they listed or delisted or selling off bits or buying other companies to merge in it's actually helping the management team access a new market grow to a new market and to help them grow where they can't get that capital from the market for some reason it's those types of managers and those types of skills
Speaker 1and what does small mean at your size so how bigger the the range of the funds that you'll invest in we
Speaker 2do use funder funds for very specific strategies so we're very agnostic as to how we implement but for the larger managers we could write a three or four hundred million dollar check to a fund and ideally that's what we would do because we've got only seven or eight people in the market and we're not going to be able to in our profit equity team and we've got a lot of managers to get across but for the smaller ones where say we can write a 50 or 70 million dollar check but they're in a strategy we really like so small us buyout for example then we would do that through a funder fund and
Speaker 1how big do those funds tend the direct funds tend to be probably
Speaker 2about a billion dollars
Speaker 1okay so you'll be a substantial investor in those funds yeah yeah we typically are okay have you thought about co-investment
Speaker 2that's an important tool in our toolkit we do do quite a bit of co-investing in all the private market asset classes and also a little bit in alongside the hedge funds and credit managers but particularly in private equity the issue with co-investing is well firstly you want the manager focused on their strategy first and foremost and their fund you don't want them worrying about are they keeping their lps happy you know have they sized it right or do they have to undersize it in the fund you don't want them worrying about are they keeping their lps happy to allow some co-investment so we don't demand it we want first and foremost the manager to be good at investing the fund but where they would have a situation where they might otherwise bring a competitor in alongside them for example we'd prefer them to bring us in and other people who are like-minded we don't try to re-underwrite the deal we've already underwritten this manager we've already backed them and we trust them so our due diligence process will be focused on is it in their skill set firstly and then we'll be able to do that in the future so we'll be able to do that in the future so we'll be able to do that in the future so we'll be able to do that in the future secondly is there alignment with the manager are they putting enough capital in are they underwriting and selling down in a secondary which we typically would avoid or are we coming in the primary deal and then are we tied to them so that we go in when they go in we go out when they go out and then lastly more of a portfolio risk point of view what is the exposure and doesn't make sense for us and so we've developed a process internally where we can do that reasonably and typically would be able to be there when the transactions close i guess the other part of it is you do get quite a good insight into the manager and their process so it does help us re-underwrite the manager if that's what we're intending
Speaker 1to do and have you done enough of it to be able to measure whether it's been value added relative to just giving that same manager more money
Speaker 2sure we've done probably 20 or 30 co-investments in private equity over the years so it's not an enormous number but it's enough to have a view we also co-invest in the venture portfolio and we've done about 40 there as well and so i would say that broadly speaking the performance is in line it's a little bit of younger portfolio and so we don't really have the same data yet that we do in the in the fund book but certainly we don't think there's an ad selection happening
Speaker 1yeah i'm fascinated to turn to venture capital with the with the fund your size how you've thought about it and how you've
Speaker 2tackled it sure yeah so the first question is why bother it's a capacity constrained strategy and will it move the needle for us i think there were a couple of things firstly our research showed that unlike almost any other asset class the strongly performing managers tend to be persistent and i think that's probably due to the fact that the entrepreneurs are attracted to the people who back the last successful deals and go to them first and that does change the so-called winner's circle does but only very slowly. And so the first decision we made was if we're going to do it, there's no point doing it at all unless we can get into the high-performing managers. I think the data we saw at the time was something like 80% of venture managers don't return capital and only 6% or 7% return enough capital to justify their existence. So that's pretty daunting statistics. The second thing was there seems to be a correlation of high-performing venture vintages with recessions. And a hypothesis that we can't really test is that when people lose their jobs, they go and start up that business and do that thing that they've always wanted to do but never got around to before. And so we thought that was something that was attractive for the fund from a diversification point of view. And then lastly, a good idea doesn't need economic growth to be successful and it doesn't need leverage. So it seems to be a correlation of high-performing venture vintages with recessions. strategy that can perform even in adverse market conditions, albeit that you have to be conscious of the flow of funds in and out of the space. And so those things together led us to a focus on early-stage venture rather than the late stage. We've tended to avoid the late stage. And we've primarily done that through funder funds because, as I said, small team, small check sizes, hard to get access to the best-performing managers. And we were lucky enough in 2009 that there were other people going the other way and we were able to get some access. And so we've worked very hard to slowly build the portfolio to the point where today it's about a bit over $2 billion of exposure, which is meaningful to some extent at the fund level. But more importantly, it's also very diversifying from the rest of the fund and that's quite valuable. And we have also, in the last three years or so, started to co-invest with the venture managers. So we do funder funds, we do directs and recently we've done some co-investments which are really follow-ons, similar to the private equity approach, where we would only do that if the manager was following on themselves and if they were saying to us, this is an attractive idea, we think you should look at it. And we've done about 30 or so of them, as I said, and that portfolio has delivered, you know, really strong over 20% net returns over 10 years now, which is very satisfying considering what's been happening in the world.
Speaker 1Yeah, you know, the Futures Fund started investing the capital in 2007. What was it like in those first two or three years?
Speaker 2So I think we were very, very lucky with timing. I actually joined right at the beginning of 2008, signed on at the end of 2007. And in the second half of 2007, the board was under immense pressure to get started with the investment program. They literally had tens of billions of dollars of cash being rolled over. Yeah, that's a huge amount of money, isn't it? Yeah, it was a huge amount of money. And it was a huge amount of money. And, you know, it was a huge amount of money. And as you know, markets were running very hot. And so they made a decision to start to put an exposure on just through index positions and to just steadily step into the market over a period of time. And David Neal, when he was hired as CIO and the person who was in the head of strategy role at the time, Tony Day, came on board before I joined. And the very first thing they did was look at markets and say, we're not sure what's going on, but we think the equity risk premium is negative. Something's wrong. And we should just stop investing. And they did, which was a very brave call. And I would say really set up the DNA of the fund ever since, which is if you have a very high conviction in something then you should act on it. And so when I joined, it was really just prior to the crisis. And I was really confronted with this problem in the infrastructure where everyone said, how will you ever get set? It's a crazy job. Assets are really expensive already. Nothing's available. And I started writing a strategy. And as I spent more time here, I ripped up that strategy at least twice because it took me a little while to understand what a one portfolio approach was that eventually emerged with a strategy that said, let's be flexible. Let's not lock into a particular asset allocation. And let's sort of approach this from first principles. And suddenly the financial crisis happened. And so fortuitously and through some good decisions made by the people who were here before me, we were sitting with about 80% in cash when layman's went. And so I was like, okay, I'm going to do this. I'm going to do this. And so fortuitously and through some good decisions made by the people who were here before me, we were sitting with about 80% in cash when broke. And so we didn't have a problem with liquidity, but we, of course, were a bit nervous about the world. And it took a little while for us to decide that it was time to start investing. But more importantly, we only had probably about a dozen people in the investment team, and we were still writing strategies and we didn't know each other and the board didn't know us. So actually, the first time I went to the board with an infrastructure investment, I had to say, what would you like the board paper to look like? Should it be five pages, 50, or 50? And they actually said, we're not sure, write one of each. So I did. But we made the decision early in 2008 that the world wasn't going to end, that something was going to happen to save it. And if you had that view, that assets look very cheap. And being somewhat timid, what we decided to do was move a lot of money into credit. And so we appointed three broad credit managers. I said, we use external managers. And in this sort of situation, there was really no way to do that. But we just wrote multi-billion dollar mandates to three managers and just said, get set, get in the market, do whatever you want, make money.
Speaker 1How much were you able to deploy as a percentage of the portfolio at the time?
Speaker 2It was probably about 15% to 20% of the portfolio into credit over about three months. So it was quite a big decision. And clearly, that decision paid off very well. Those initial investments returned above 20%.
Speaker 1Yeah. So you were pretty senior in the capital structure then?
Speaker 2Yeah. It was all senior and investment grade credit at that time. There wasn't much point in buying high yield if you could get those returns in investment grade. As the crisis unfolded, that portfolio started to rotate out of investment grade into higher risks, high yield and other things. And at some point, we decided that it was appropriate to start the investment process into equities again and kick that off. And also by then, we had started to build teams, in the private markets. And so we started to get set in the private markets. And in fact, back then in about 2009, end of 2008, 2009, we were buying core infrastructure and core property because they looked very attractive given where prices had gone to. So in the decade or so since then, we've rolled those assets out of the portfolio and replaced them with higher risk assets where we think we're getting better rewarded.
Speaker 1And so today, you had mentioned what sounded like a, let's say, a cost. Yeah, it's a very cautious macro view. How are you thinking about the flexible positioning of the portfolio?
Speaker 2Well, we've built a lot more process in the 10 years since then, which is both good, but also we need to be careful not to let that lock us into a position that isn't the best position. So we run a couple of tests. We suffer, like many Australians, from a very volatile currency. And so it also tends to be correlated with risk. The second thing, though, is if we have not quite so severe an event, but something close to it, we actually want to be able to buy cheap assets. And the option value of flexibility is not something that traditional portfolio theory really takes into account. And so that's why you see us sitting with sort of a bit over 15% in cash and why we manage our illiquid asset pool carefully. Because while you would hope you get an illiquidity premium from those assets, it also means that you're not going to be able to buy cheap assets. And so that's means your portfolio isn't as flexible as it might be in those sort of scenarios and there is an opportunity cost that arises. So we try to build the portfolio to those liquidity metrics or flexibility constraints and then look at, okay, if that's our capital budget, our risk budget, our liquidity budget, how should we best spend it? What are the things that are returning the best risk-adjusted returns given those whole portfolio budgets?
Speaker 1And what does that look like
Speaker 2today? Well, today we look at the world asset prices are expensive. They're probably slightly less expensive than they looked a year or two ago because we've had at least in the US and in other places, a strong earnings print or series of prints. So the economy is quite healthy. And so risk has become more attractive. And towards the end of last year, we increased the risk in the portfolio as a result. But on the horizon, we've got a couple of really significant issues. One is just the business cycle returning in the US. We've got the Fed raising rates and shrinking its balance sheet, liquidity coming out of the system. And usually that ends in a recession. In fact, while we've got some unusual experience here in Australia, you would expect a recession in the US in the next two, three, four years, something like that. We've also got a very strong fiscal impulse at the moment going through, but the current view is that that will roll off around the same time. So we think the chance of a recession in the US is quite high over the next, say, a three-year time horizon. And it doesn't appear that markets are currently pricing that in. Secondly, we've got really, as a consequence, I would say, of the financial crisis and the monetary policy response, which inflated asset values, but kept wages down, we've got a growing populist politics trend across the world. And that's true in almost every developed market. It's more reported against in the US, obviously, at the moment, but it's true in most markets. And populist politics, which is not unusual in history, usually ends in lower growth because tariffs and trade restrictions usually lead to that or other types of protectionism and higher inflation. And so we've got some skirmishes going on between the US and China currently, and there is the potential for that to become far more significant. And so I think if we look at the world today, I would say there's a lot more downside risk than upside risk. And I think there's a lot more upside that we can see. And the only upside scenario is we can really come up with a sort of productivity boosts based on things that aren't in the data yet, and we don't know what they are. And so it's not really likely that central banks can respond again in the same way they did after the last financial crisis, because they've used up that ammunition. So we're not expecting a financial crisis. We think banks are more robust now and markets are better regulated, but we certainly think the risk of a recession and some rebate is going to be higher. And so I think that's a good thing. Pricing of risk assets to below average is likely in that scenario, and markets aren't pricing for that. So we have been reducing risk in the portfolio gradually. And as we sit today, we're just slightly below neutral, because we think the cost of foregoing some return in good market scenarios over the next year or two is far, far outweighed by the opportunity cost of getting caught up in the market. In a downturn in markets and not having the ability to invest into that at the time when asset prices are cheap.
Speaker 1And when you say neutral, is that neutral beta across the entire portfolio?
Speaker 2Yeah. So the way we think about that is we map every asset onto a factor lens. And at its very simplest, we'll just think of two factors, cash and equity portfolio. And so we tend to think about risk in the portfolio on that basis. We don't. We don't know whether any of those scenarios will play out. And the most likely outcome is some other one will play out completely that we haven't even thought of. So it's important to be humble about this. We do know that risk isn't being particularly well rewarded right now. And we do know that all the risks I discussed are out there. And so it doesn't seem sensible to be taking a lot more risk than normal in this market. I can't envisage a view other than a very short-term view why you could support taking that risk. I can't envisage taking more than average risk at the moment, for example, for a long-term investor. So going back to the beginning, you have to have a clear set of objectives and risk parameters as a language that you can talk about with, in our case, our board and our investment committee. And we have this very open conversation with the board. And so the sort of scenario we're talking about is, well, if equity markets are doing 10, say, which is pretty healthy considering where they're priced today. And we. We have a diversified portfolio. And in that scenario, we're only doing seven or eight, which beats our mandate. But in a big drawdown, we might only lose. 10% rather than 30% and then we can invest into that and deliver 15% or 20% returns beyond that, is that a risk worth taking? And we think it is because we're an absolute return investor over the long run. We don't have to worry about peer risk. We don't have our performance published in league tables annually, let alone quarterly like some funds. And so we can just focus on that long-term goal. The other thing to think about, and as I said before, the industry doesn't do enough of this, is thinking about the risk part, not just the return part. And so we sort of think about volatility, but also Sharpe ratio. And it's a hard thing to measure and there's all sorts of debates you could have about it. But in terms of our 10-year Sharpe ratio, it's about 1.3, which we think for a fund like ours is pretty good.
Speaker 1Yeah. Yeah. How did you make decisions? As a team?
Speaker 2Well, it depends how big the decision is. And I would say that we're evolving this at the moment, but the big picture portfolio decisions, how much risk should we have in what scenarios are we worried about? We make those decisions at the board level. But obviously those views are filtered up from the team to the internal investment committee and then recommended to the board.
Speaker 1And how many people sit on the board?
Speaker 2Seven. And they're appointed by the government. They're appointed for fixed terms. They're not allowed to be. They're appointed by current politicians and they've all got financial services skills. So we're very lucky that the governance structure that was designed for us by the creators of the fund is very robust. And really, I would say, is the whole reason why we've been able to deliver what we have.
Speaker 1What's the structure of your team?
Speaker 2So the investment team, I said about 60 people. It's split into three teams. One is public markets and there's a group doing equity. There's a group doing opportunities, which includes the long-short. There's a group doing debt, and that includes both public and private debt. There's a group doing all the overlays, so all the derivative positions that shape the portfolio and put on interest rate, currency, and some option tail-shaping strategies. And then there's the hedge fund team. We call it alternatives. They also do alternative risk premium, things like reinsurance. And so there's a deputy CIO, David George, who leads that team. And we'd like to say that we're very fortunate that we're able to do that. And that's what we're doing. We're like to think that those skills are fungible and that we can share the insights across those sub-teams and benefit from each other's skills and opportunity sets. And then we've got a private market team led by Wendy Norris, and that's infrastructure, property, and private equity teams. And they obviously focus on their areas, but increasingly they're sharing their skills and resources across those areas as well. And then we have a portfolio strategy team, which is a top-down portfolio design team. And they're also tasked with looking at the economic situation, how markets are priced, and looking at portfolio risk settings and investment process that I've been talking about. My job actually is much more about team structure and process and strategy, and most importantly, culture, than about making investment decisions.
Speaker 1What's the nature of that culture?
Speaker 2Well, I would hope it's very collaborative. I think we aren't into star investors or single people. Taking the glory, we're into a real team effort. We trust each other. We empower people to make decisions, and we have to support them with the right framework so they know what decisions they should be making and when they need to escalate something and how much risk they can take. We do vigorously debate ideas with each other in a very open way, and we encourage that. And so, we certainly think that diversity of thinking is really important. Having different people around the table with different backgrounds, different experience, and that clearly in investing, there's no right or wrong answer, and no one really knows what will happen. And so, the more views you've got, the more able you are to make a good decision. And then, importantly, it's a no-blame culture. So, we know we won't get all the decisions right. In fact, we'll get a lot of them wrong. And so, as long as we've made those decisions in the right way, we just move forward and learn from it. And we might ask the questions, what do we learn from this? Can we improve our process? But then, we just get on with life.
Speaker 1How have you tried to address human biases and improve them on your team?
Speaker 2Yeah. The first thing is to acknowledge them. And so, we're all very logical, analytical people here working in investment markets. And so, actually, we've got a really good chief culture officer, and she's led our thinking in this space. She's a psychologist. So, she's been great at educating, firstly, me, and then the rest of the team using data. So, it's very clear from the data that diverse teams make better decisions when presented with cognitive problems, and they have time to debate them, as opposed to teams that have to make very quick decisions, like a sports team or armed forces group or something like that. And so, using that, getting buy-in across the team for that observation, we've then looked at our own processes. And the classic one is an investment committee, where you have some wise and old person, usually a male, chairing the meeting, debating on some issues, but then dominating the conversation, or letting some people with loud voices dominate the conversation over others, and go around the table and vote one at a time, raising your issues. Well, it takes a strong-willed and courageous person, then, to vote against the chair, or it might be your boss, or the views of the other people who might have been in the organisation longer than you. Or, in some cultures, actually, I just never would do that. You know, in some Asian cultures, they never would argue against the views of their boss, but actually, that could be the most important thing they should do. So, we've transitioned to a model now for some of our committees, and it's in trial, where we canvass views the day before the meeting, whether people are inclined to vote for or against something, and why. And then the chair of the meeting gets that information. They can feed it back to the team, so that the team can firstly focus their presentation on the issues rather than wasting time just repeating what's in the paper. And secondly, use the time in the meeting where it's most needed, but then we can call out those views, so that even if it's only one person who says, "I don't like this because. " the chair can actually say, "Well, you raised a concern about this. Why don't you share that concern with everyone?" And we can see if we can either allay that or agree with it, and that could take us in a different direction. So, it comes to how we chair the meeting as well. And it's very important in the dynamic that the chair or me if I'm not the chair, are supporting those views and encouraging people to do that, and have the dynamic where we're all working together for the good of the whole portfolio. There's no us and them. There's no, "Let's just get through this committee so we can do what we want." It's, you're still responsible if you're presenting the paper, but it's, "Do they know something I don't? Have I got an expertise that I don't? How can I use that so we all get to a better position?" And so, we're trying to change the culture to that. We've got a way to go, but we're
Speaker 1getting there. And how's everyone incentivized in their compensation?
Speaker 2So, obviously, we get base salaries, but we also have a bonus arrangement, which is linked to some extent to personal goals, which might be about the team or the individual responsibilities, and they're assessed by the managers. But the quantitative performance measure, and the more senior you are, the more important that is, is solely based on the rolling three-year whole of fund performance in an absolute sense. So, it's to create alignment, sort of whole portfolio thinking that I've been talking about.
Speaker 1Yeah. What do you think are the core differences between a US-based, kind of US-focused investor and an Aussie-based investor?
Speaker 2It's very luxurious to be a US investor these days because you don't have to worry about currency. And that's probably the most important thing, the most important difference, I think, that there's so many opportunities in the US market in US dollars, and you don't even have to think about it. And if you decide to go offshore, then suddenly that's a big decision. Whereas if you sit here in Australia, we don't have that luxury. And as I said before, the Aussie dollar is very volatile compared to the US dollar. So, that is a big impact on portfolio construction. But there are other differences too. I would say, and it's easy for me sitting on the other side of the world, but I would say that the US investors largely are quite introspective. I think we have a very different view of the rise of China and the impact China's having on the global economy than most people I speak to in the US who rarely talk about it. And we've probably got a much more open mindset to the benefit of exposure to emerging markets than a lot of the US investors I speak to.
Speaker 1Yeah. So, what is that view on China?
Speaker 2Well, it's probably one of the oldest civilizations in the world. So, we've got a lot to learn from them just in that respect. It's an enormous country with an enormous population, and it rightly deserves to be the biggest economy in the world, and it no doubt will be before too long. And the Chinese government, whatever you think of the political structure and regime in China, has done a really amazing job in improving the life of the average Chinese person in the last two generations. so that we've had this huge and one-off tailwind investment markets and global economies but from the creation of a middle class in China and they're very aspirational the policy makers are very clever and they have a plan and so one of the things I'm most excited about actually in the world at the moment is the opportunities that the creation of that middle class consumption generation and an investing population there's a huge internal domestic investment markets and they haven't really been opened up to the world yet but they will be the currency has become tradable and will become more tradable over time and so someone who's interested in the long term really needs to be aware of that and learning about it and thinking about what is their strategy.
Speaker 1How have you thought about allocating when your domestic economy can be tied to what's happening in China then you have a whole sort of Chinese market opportunities?
Speaker 2Yeah so you're right so the first thing is you know if you're Australian you have an exposure to China just in the Aussie dollar and the local economy so we're not setting out for example to play commodities because we feel like we've got enough of that exposure already and if we look at we sort of loosely call it old China and new China so old China is the investment driven wealth creation through building roads and buildings particularly property investment there's all sorts of debates about whether that was over capitalized and whether capital allocation was efficient we don't get into that all we would say is we don't see that as a particularly attractive investment opportunity right now but the new China the creation of significant demand for health care for education for entertainment opportunities as people become middle class the trading up in terms of the types of goods and services that people buy those opportunities are absolutely tremendous and so we've been playing them a little bit in the equity market we're working on some further strategies there but significantly in our private equity program where we have quite a bit of onshore Chinese exposure really playing those themes and then the tech space in China is really interesting at the moment too and there's they're really market leaders in a lot of cases and so we have a venture program focused on China as well. So now
Speaker 1that the fund's been up for 12 years things have sort of settled in you said there's processes now what's the next step? Well I think we're going to have to wait and see as you look out for the next let's say three to five years what are the key initiatives you're looking at to improve what you're doing?
Speaker 2I think the first one is actually about our people and the way we interact with each other so I sort of look at the traditional organization which has a top-down hierarchy where you have one person sitting at the top and then a few people below them and so on and so them so on and the authority cascades down and I think that struck is just too inflexible and too slow to make decisions to meet the challenge of the world that sits in front of us. And frankly, our portfolio is too complex as well. And so I think that we need to move much more towards a sort of a network organisation where everyone knows what their role is, where they're in touch with a set of opportunities and a set of information and where we have to use our structure to empower those people to make the decisions that's appropriate for them and to take the information they generate and bring it back to the rest of the portfolio and the rest of the investors. Now, we're not there. It's a hard thing to do. But I do think that having a venture program also exposes us to sort of the technology that's available to help people collaborate. And we've started to implement some of that. So we're using Confluence and SharePoint, for example, for internal teams to be able to communicate with each other. And we're investing into our own technology quite heavily to uphold that. And I think for the next couple of years, a lot of my focus is going to be on that internal structure and team to get to that space. So it's not really about we have to take the investment program here or there. Actually, I have no idea what will happen in investment markets. I know we just have to have an internal structure and process that can adapt as that evolves.
Speaker 1I guess I want to ask one last question about how you've thought about fees because you're in this interesting inflection point where you have a lot of external managers, but you also have a lot of capital and bargaining power. So how have you tackled that with your external managers?
Speaker 2Yeah, we do think a lot about fees. It's very important, of course. But the first point is we're focused on net returns. And some of our local peers here in superannuation who have to compete for members have decided to go down a road of setting up a business. And so we've been thinking a lot about fees. And I think it's a budget for the whole fund and then reporting those fees as a competitive advantage in their marketing. And we think that risks cutting out whole swathes of the opportunity set, the higher fee areas of hedge funds and private equity and venture in particular. And that would be fine if they didn't do much for your portfolio. But I think they're really important for a properly diversified portfolio going forward. So we're agnostic as to the level we're going to be in. And I think that's something that we need to look at. And I think we don't like paying them. But we mainly think about net returns. And so that's the first thing. However, the second thing is, as I was alluding to when I was talking about equities, there's no point paying fees for things you can buy more cheaply. And so each team thinks very hard about what are their arrangements and are we getting bang for our buck. So I'll give you an example in infrastructure. Some years ago, we were talking about the fact that we had a lot of Well, the typical fee model in infrastructure is come into our fund, we'll charge you. If we're not too avaricious, we'll charge you 1% base fee and 10% over 8% or something like that. If we are, we'll charge you 2 and 20 like a private equity fund. And if you're buying core infrastructure assets where most of the return is coming from continued economic growth or flat to declining bond rates, that's not manager skill. That's an economic view that I can buy in my fund using liquid market proxies. So there's no point paying high fees for that. If the strategy is highly value added, if they're turning around poor performing businesses, if they're growing businesses through add-ons and creating something and then exiting much more like a private equity manager would, then maybe it is worth paying. So that's the insight we bring. And in the case of infrastructure, a few years ago, we actually, so I said we only invest through external managers. That is true. We only invest through external managers. That is true. That is true. But there was an opportunity in Australia to buy some domestic airports from a listed company. And we wanted to use a manager. But when we started talking to the market, we found that they weren't aligned sufficiently. They all wanted to put it into funds and structures where we couldn't get enough capacity or where they locked themselves in as a manager forever, or where they charged fees that were not really sensible for those type of assets. So we actually went out, surprised the managers, and then acquired some assets, which left us with essentially two large airport exposures here in Australia, Melbourne and Perth Airport, which were approximately a billion dollars each of value. Now, in this case, we'd bought the asset, and we understood them, and we are going to make the decision about when we should sell them and if and why. And so we don't want to buy, you know, to hire a manager that can take the value away from those decisions. So the board said to me, why don't you manage the assets? You bought them. You know how to do this. You used to be an infrastructure fund manager. And I could, and I actually built a business case or a plan to say, how would I do that? But I felt like hiring eight or so people that I thought we would need to do that well risked our culture because how do you incentivise them? Do you incentivise them on the whole fund when they're just managing one asset? And what if I want to sell those assets? What do you do? How do you incentivise them to do that? And so we decided to hire an external manager. So we went to the market and we said, we want you to bid to manage these assets. And we want, airports really, they're, you know, they earn aeronautical revenue, but they're also shopping centres. And they're sometimes property development plays as well if they've got a land bank. So we want you to bring your property people or a partner who's got that expertise alongside. And it was really interesting in Australia where there's a number of fund managers who have both infrastructure and property strategies. Those teams had never worked together. So we sort of said, don't turn up if you don't, if you can't do that. And then secondly, we want to know the people who will be working on these assets, how much time they'll be spending on it, and we'll pay you a cost plus. And so we're happy to pay you a profit, but we want to know what that is you can bid on that basis. So that was unusual in space. Economy does well, and the value of the asset increases. That's not your doing. It might even be that this particular business has lost market share, but still grown in value. And so we decided collaboratively to set one and three year operating goals, how much revenue per car park, whether the CapEx program was delivered on time and on budget, what's the spend rate per passenger in the retail business. And we would agree fixed dollar bonuses based on the share of the value created by a business. achieving those metrics back to the manager and you sit down every year and renegotiate those bonuses and if we can't agree then there are none is the approach and so we also said we've bought these assets we want to be able to terminate at any time we want although we recognized there was an initial cost in setting up the mandate so we decided to pay them a sort of a demobilization fee on a schedule for the first three years yeah and so as a result of the wonders of competition we actually achieved what we wanted with both of those assets we think we've got a more engaged manager who's working harder on creating value than a traditional infrastructure manager would for a core asset and as it happens the fee we're paying is substantially lower than what it might have been under the old arrangement and i would encourage any of your listeners who happen to be in a role where they could do that to think about whether their managers are actually adding value and to speak up and to make a difference
Speaker 1yeah and yet you're not planning to do more of that was that a one-off where there are those
Speaker 2types of opportunities we're very happy to do that but again we're not arrogant about it you know in a situation where a manager is finding an opportunity and bringing it to us we think they deserve to be compensated for that we just want to make sure that we're paying for actual value add we're not paying for beta we're not paying for luck we're not paying for useful
Speaker 1across your portfolio roughly how much would you say you've achieved that objective where what you're paying today is really a good fair assessment of value add i think we're there
Speaker 2in every part of the portfolio to a point to a point but there's always room for improvement and i think as technology improves you know i would aspire to look at those infrastructure or property assets and regress them against the broad factors just like we do with the equity managers and the hedge fund managers in the more liquid space and say how much of this return is due to discount rate compression or changes in economic growth assumptions or inflation how much is due to your actual skill and the industry has a way to go to evolve to that model but what's happening in infrastructure and property is the big funds rather than doing that they're internalizing as you pointed out and that is creating pressure on the industry and that will force change and i think the same is true in equities and hedge funds but in a slightly different
Speaker 1way yeah great well ralph i want to leave a little time to turn some close and questions but i think before we dive in as you know from the first time we spoke a number of months ago my historical first closing question was this question about what's your favorite sports moment and you told me you didn't like that question why don't you explain why i
Speaker 2don't think it's an appropriate question we've done a lot of work internally on how to get diversity of thought into decision making and we've done a lot of work educating ourselves onto unconscious bias and i think the problem with the sports question is i would hazard to guess that more males than females are probably interested in sports although i'm not saying females aren't and that your listeners are probably thinking about at least a chunk of them are thinking about how can i get to be a cio or a portfolio manager or some type of lead consultant and the point i'd like to make is you don't have to be a sports fan to get there you know all people are different some are sports fans some aren't yeah
Speaker 1which is great so i've been working on the wording and so here's my new wording for the next question i'd like to make is you don't have to be this first question what was your favorite extracurricular achievement okay that's probably
Speaker 2even a harder one to answer but that's okay so leaving aside work and family which obviously take up much of my time i would say in the last few years i've really decided to try to put something back into the local community and i've gone on a couple of not-for-profit boards one is the school where my kids go and somehow i've ended up as the treasurer there and we're doing some work around the sustainability of sports and i've been doing some work around the sustainability of the capital budget and how we can get the school fees down and i think putting effort into educating kids and making sure that's sustainable in the long term is really important i've also gone on the board of a community foundation called the lord mayor's charitable foundation here in melbourne that's a 90 year old institution that looks at the problems in and around melbourne which are currently things like homelessness kids education integrating aged people and migrants into society and raises an investor corpus and gives away about 10 million dollars a year and i'm chairing the investment committee there so i feel like we're making a difference and that's really
Speaker 1important that's great what's your biggest investment pet peeve
Speaker 2i think it's probably a couple of things one is just people who assume the future will be like the past and i don't think that's a valid assumption you know there's a whole lot of things over the last 50 to 80 years a huge demographic boom post-war that have meant that certain things behaved the way they did that i just don't think are likely to continue so i think we have to go back to first principles now and someone who says well i've done it before and it worked so therefore it will work again i'll just get irritated by that approach yeah and link to that people who just don't understand why something works like if if something's a great investment idea there's got to be a reason and if you don't know the reason don't do it
Speaker 1right it's good all right here's a new one if you would look one person dead or alive one person in the eye shake her or his hand and just say thank you who would it be and why it's an easy
Speaker 2question for me to answer but it has nothing to do with investing i'm a real animation fan and i love theme parks and so for me it would be walt disney he's a person who was an innovator who was prepared to take a lot of risk who went broke more than once he really bet everything on his vision but also he used technology to communicate with the masses so he was the first person to take a lot of risk and he was the first person to take a lot of risk and he was the first person in an existing movie studio to use television and he was roundly criticized for that he built the first theme park and he really saw people who worked for him for their talents and didn't really care what the rapper was despite some of the rumors about him in my readings you know he backed all sorts of people from all types of backgrounds and so it would be fascinating to talk to him about that
Speaker 1what teaching from your parents has most stayed
Speaker 2with you uh pretty simple i think they're sort of pretty straightforward people just work hard and be patient don't expect everything to come to you straight away and be prepared to take a risk if it comes along
Speaker 1what information do you read more than any other
Speaker 2i'll get a lot of things to read and some of the writings from our hedge funds and things like that are interesting but really i read the work of our internal team because they synthesize all of that together into what's important and and i find that the most valuable i have any spare time what i try to do now is read about historic economic conditions and i'm particularly interested actually in a period called the gilded age followed by the progressive era in the u.s 1880 to 1920 when following the railway bubble and bust and financial crisis there was a huge rise in populism that led to theodore roosevelt getting elected and there's a lot to learn i think from understanding that
Speaker 1period last one what life lesson have you learned that you wish you knew a lot earlier in your life that i
Speaker 2don't know all the answers and that other people quite often know better than me or certainly they've got different views to me so really how to listen to other people that's great raf
Speaker 1thanks so much for taking the time really enjoyed it thanks ted
Speaker 2before we get
Speaker 1going i'd like to invite you to join the capital allocators think tank a premium content subscription service where you can discuss each episode with me and the guests alongside allocators of sizable pools of capital you'll also gain access to the library of transcripts of past episodes visit capital allocators podcast.com and click the premium content button to sign up for either a corporate or individual membership thanks for your support
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